Tuesday, August 11, 2009

Sobering Words From Bob Prechter

Robert Prechter of Elliott Wave International and the leading proponent of Socionomics (social mood determines events, rather than the other way around) has been, in my mind, one of the only analysts/pundits/economists out there who has legitimately called both the deflationary credit crisis and the ensuing rally that we are in now. His unique method tracks the stock market as a barometer of social mood which patterns itself in distinct formations representing fear and greed. Very few others are willing to subscribe to his theories and quite understandably so. They imply that human nature leaves us with very little to determine on our own. More accurately: the character of society and the economy are preordained, but the exact events that result are not.

Similar parallels can be drawn with generational theories put forward by Neil Howe and William Strauss and continued by John Xenakis. These suggest that generational archetypal characteristics are defined and develop based on the environment they have been raised in, which itself moves in predictable cycles making future socioeconomic shifts an inevitability.

The two separate theories are not entirely compatible, but they share more similarities than they do differences, the primary one being that there is very little any person, leader or government can do to alter the broad course of the future. Both theories can say, for example, that society in general is more likely to embrace a fanatical leader at certain times than others; that society in general is more likely to reject international cooperation, free trade, high taxes, social programs, etc at certain points in their cycles; that women in general will be more inclined to dress and act conservatively, bear children, etc after experiencing certain types of events earlier in their lives. Neither theory can say, however, what they will wear, or what level of taxation will be acceptable, or what kind of fanatical leader will be embraced.

I subscribe to both of these theories because they appear to have a far better record in predicting broad changes in the economy, and therefore make investing decisions much easier. I admit that they are disturbing in a way. As a person who has studied economics at a theoretical level, and believe that certain policies and social structures will prove to be more beneficial than others, it is difficult to reconcile that no matter what path we choose to take, there will always be social and economic cycles and the undesirable consequences inherent in them. Then again, I remember a wise man advising that the ability to hold two opposing views simultaneously is somehow virtuous. But I digress...

The reason I believe that Prechter has been nailing the tops and bottoms of the last few years is because of his contrary position as to the causal nature of social and economic events. That's not to say he can't be wrong. He has, in fact, been very wrong in the past, thinking that the '87 crash was going to mark the same kind of top he thinks we have made in '07. But to me, an extra 20 years of experience and time to further develop his method makes his opinion more worth listening to, not less. He does not seem to make media appearances discussing his directional calls unless the wave pattern is very compelling.

This week he made an appearance on Yahoo's Tech Ticker. The four short videos can be found below in no particular order (thanks to reader Mike for the heads up):

Prechter does hedge with the "corrective waves are complex" line, so I would be cautious to start shorting anything very aggressively. The markets seem to be hitting their maximum upside targets before retracing to their minimum targets, which is still a sign of strength and deserving of respect. Bob mentions extremely positive sentiment on equities (93% bulls) which, of course, could turn into 95% or 98% just as easily with another final rally toward S&P 1100/Dow 10000.

Prechter would say that the purpose of this rally is to "convince as many people as possible that the worst is over." John Xenakis has something he calls "The Principle of Maximum Ruin," where the most people possible are made to suffer the greatest losses possible. And as a trader/investor, I am most definitely familiar with "The Path of Maximum Frustration," where markets will tend to go just far enough to convince you that you've erred before turning around.

We saw this kind of activity from 2005-2007, when real estate had already rolled over, subprime mortgages were blowing up and debts were mounting even higher. All the while the market continued to march higher and all everybody cared about was the next big merger, or how many decades the cinderella economy/great moderation would last. In August of 2007, everything the bears had been talking about for decades started to matter and the markets dropped - only to frustrate as many of them (myself included) to the furthest extent possibe by rallying to new highs 3 months later.

We also saw the same type of activity in late 2008. With the market dropping more than 50% and then rebounding over 27%, the bulls were celebrating a successful recovery and analogies to 1987 were flying all over the place. Months later, the markets collapsed again, methodically eliminating any bullish sentiment before embarking on the largest rally over a 5 month period in 8 decades. The same pattern is at work. But there are limited ways to gauge the extent without the benefit of hindsight.

Because I do believe in the "corrective" nature of this rally, it has always been a very risky proposition for me to justify much long side exposure. It is difficult to see it continue higher without participating much. I bought some November calls in AIG a few weeks ago which appears to be working (that can change fast with such volatility), and I am still holding my LEAP puts on the S&P. Mastering the emotions of such volatile times is no easy proposition, which is why I think both Socionomic and Generational patterns are more important than ever. They seem to provide the only believable explanation of such volatility and are, in my opinion, very likely to be proven correct over the coming years.

I don't often "do" advice in this space, but I think caution is the best course at this time. Pressing short side bets could prove disastrous if done too soon. And chasing the long side can eat into precious capital when inevitably done right at the top.

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occdude said...

Prechters time has come me thinks. Dow 10000 is too obvious for a cataclysmic correction. It will either come before or slightly after when the last dollar of the "hapless and hopless" has entered the fray. I think it is gonna be a technical head fake, I think Goldman is gonna be on the other side of it and in fact partly responsible for it.

So don't forget that the enemy has technicians as well, and they made their money off of the shorts in the 2nd quarter so now its the long side of the market which needs to pay Goldman its tribute.

Roger J said...

Prechter indeed seems to have learned a lot from his mistakes & improve. It's interesting he's not that often on the media spotlight even on the face of probably the greatest bear market in our lives.

Last time he was on the media spotlight after 1987 crash, in which his EWI subscriptions shot up stratospherically high. After that, it all goes awry (DOW 400 call, etc.)... making him insulted and overlooked by many. I guess those spotlight plucked him out from his usual contrarian positions. So, perhaps in a way... his longtime (almost 2 decades) of failure & crowd distrusts work in his way to his calls on this great bear market.

In that line, we certainly hope that Prechter should hope that he doesn't get that much media attention -- to preserve his contrarian outset.

Now, regarding markets Matt. One interesting correlation I found was this: in October 2007, SPX & Shanghai markets top at around the same time (second-week, if I recall correctly). As of now, it seems Shanghai market is already rolling over. There's an uptrend-line break, confirmed w/ MACD bearish divergence & RSI trendline break. So, if it is to follow the same sequence, the market top is already in by now. This confirmation is followed by other indicators, too: USD bottoming, commodities start declining (will it continue?).

But even if the top is in by now, if we look back, the drop was slow & steady (EWs call it wave 1 of 1). Only in the later stages (wave 3 of 1) the drop got violent & crazy. So... if we are to expect violent & unprecedented declines, EWers naturally should wait for wave 3 of 3. Wave 3 is typically the most intense of all.

Although this storyline looks very fine, almost perfect, to generate the greatest amount of frustration among both bulls & bears, it may not necessarily play out. I already see many bearish economists who got it right for the last plunge ready to call that we might have seen the bottom. I'm amazed that even Mish included -- although he also has doubts. So, it does show that degree of frustration (in this case to the bears) to relatively great extents.

So, if it indeed is to continue with even more violent plunges, I imagine it will be coincident (notice I'm not implying causation here) with massive blow-ups at some places not widely on the spotlight. It may well be already widely publicized, just the spotlight is not quite there. As a familiar reader of yours, the scenario may involve Europe & China.

By the way, do you use EWs a lot, Matt? EWI's call is for DOW @ 400. Seems outrageous to me, 2-3000 may be still digestible (quite hard already!), but not 400. Saying that, I definitely agree with their socionomics view of human nature.

mannfm11 said...

I have been at least a reader of Prechter since 1998. I traded some of his advice in the LTCM fiasco and bought the farm. In fact, I have an amazing hand drawn chart of the SPX in 98. I think Bob's count has been off for years, but his premesis has been right on.

Bob wasn't wrong in 87. He was wrong about how far the market could go afterwards. He actually nailed the 87 top pretty closely. He called it a 4th wave and 5 was not supposed to be what it was, if it was in fact 5. I believe it was 3 and I also believe that we are in the midst of a massive A wave that will be a 5 waver.

People don't understand what is happening here. Prechter wrote about it in at the Crest when he mentioned this being a credit economy. There isn't any money in a credit economy, only credit. There isn't even anything denominated as money or in units of money. One could suppose that gold was worth a certain amount, but what amount would that be? In credit, there is nothing, but there is also everything. Bob spoke about how credit depended on faith, faith of the borrower he could pay and faith of the lender he would be paid. Where is that equation today?

Banks create credit, but they cannot have money in the sense they have had money in the past. A bank is 100% a balance sheet made up of numbers and the numbers have to show it has the capacity to pay its losses or it isn't a bank. But, only a bank can create what the numbers represent and if that creation quits growing, it take all down a black hole. It is a lot more complex than the Fed printing money, the government doing a TARP or the suspension of mark to market when all is said and done. At least when all went bust before there was a Federal Reserve, there was gold and it was the money. People are merely kidding themselves when they claim that today. Money will be food or gasoline or tobacco or whiskey if there is no credit, maybe before it will be gold. If you need a drink or a bite, a coin with no certain value isn't going to go far.

Anonymous said...

With real consumer spending forecast to grow 1.4% annually over the next decade and real GDP 2.0%, real consumption's share of GDP falls from 71.0% last year to 66.5% in 2018

Slow Long-Term Growth,
And Government's Response
By Gary Shilling
I think it may fall quicker than that since value is stifled by political economy malinvestments.
I think water and food instability's will provide more lucid reflection sooner than later.
Best guess from data suggest 2 year bubbles as we are "contrived"
to even move forward. aedens

Mike said...

I agree with Prechter that the March lows will not hold, but because of govt intervention and mark to market being eliminated, I don't think it's going to be nearly as easy to make money being short as it was over the past few years. Instead, I think investing in gold and gold mining stocks is a safer bet, given the potential for massive money printing and/or severe economic hardship. There are a few mining stocks that could benefit greatly from a rise in the gold price. In particular, Golden Star Resources, trades at one of the cheapest cash flow per share valuations in the industry. If the company is able to continue to bring down its cost structure, then the valuation gap will shrink and the shares have the opportunity to appreciate.

Adrian said...

I have been subscribing to Bob's newsletter since 1995, and had the benefit of living through a period of deflation in Hong Kong from 1998-2003. After reading his book "At the Crest of the Tidal Wave" in 1996, what happened in Hong Kong including the massive government intervention came as no surprise. I think Bob is the smartest analyst I have ever read, and probably the smartest person I know. I got out of the stock market when the Hang Seng was above 30,000, but decided not to jump back in in March because countertrend rallies are tricky. I bet I made with some friends that HSBC, the largest company by valuation locally, would go from $140 to <$45 did get me a free dinner. (It bottomed at $33. Damn !)
If you read his books careful and analyze the current situation with regards to the credit bubble, calls for 90%+ declines for equities and commodities do not only sound plausible, but downright logical. But when I try to explain it to my friends, some of whom are highly educated professionals, nobody would believe it. That is probably why we are not all billionaires !

Anonymous said...

Matt please remember some Geocorporate seen this coming also.
We also waited for the predicated business market cycle to restart.
Many supply side Aerospace players have that productivity in the business plan to even get the elaborated contract. We have to be carefull what we say and why since you already know that but rest assured TD is correct to a percentage Matt and the Dow is deflated and commodity I feel will follow in best guess 3 to 6 quarters. IMO watch natural gas for raws as leading indicator Aedens

Willy2 said...

Watch the Euro/Yen (exchange) rate and/or the Euro/USD rate!!! These are the "Speculators" indicators. A MUST WATCH !!!

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